Opinion: The Dallas pension fiasco could happen in your state or city too

The worst case for those in the pension plan? Benefits slashed in half — or more

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Teamsters Union retirees protest in 2016 against the possibility of deep cuts to their pension benefits.

By

JonathanRochford

The recent blow-up of the Dallas Police and Fire Pension System was entirely predictable. While it is tempting to blame unusual circumstances for the recent freeze of redemptions and likely substantial reductions to pensions for those still in the fund, many other American pension funds are heading down the same road.

The combination of overpriced financial markets, inadequate contributions and overly generous pension promises mean dozens of U.S. local and state government pension plans will end up in the same situation in the coming decade.

So what happened in Dallas and why will it happen elsewhere?

The Dallas pension plan has been underfunded for many years, with the situation worsening recently. On Jan. 1, 2016, it had $2.68 billion of assets against $5.95 billion of liabilities, making the funding ratio a mere 45.1%. Despite equity markets recovering strongly over the last seven years, the value of the assets has fallen while the value of the liabilities has grown rapidly.

The story of how such a seemingly odd outcome could occur dates back to decisions made long before the 2008 financial crisis.

Dallas Police and Fire Pension System

In the late 1990s, returns in financial markets had been strong for years, leading many to believe that exceptional returns would continue. The board that ran the Dallas plan decided that more generous pension terms could be offered and that these could be funded by the higher expected returns without needing greater contributions from the Dallas municipality and its taxpayers. Exceptionally generous terms were introduced, including the now notorious DROP accounts and inflated assumptions for cost of living adjustments.

Dallas police and fire personnel were being offered the equivalent of a free lunch and they took full advantage.

In the 2000s, the pension plan made some unusual investment decisions: A disproportionate amount of plan assets were invested in illiquid and exotic alternative investments. Write-downs have come in the last two years, after a change in management.

Throughout 2016, the pension board, the municipality and state government bickered over who was responsible and who should pay to fix the mess. The pension board recognized the huge problem but offered only minor concessions, arguing that plan participants were entitled to be paid in full. It asked the municipality for a one-off $1.1 billion, equivalent to almost one year’s general fund revenue for the municipality.

Everyone is looking to blame someone else, but not everyone has accepted that drastic pension cuts are inevitable.

As the funding ratio plummeted, plan participants became concerned that their generous pension entitlements might not be met. Police officers with high balances retired in record numbers, pulling out $500 million in four months in late 2016.

In November, when faced with $154 million of redemption requests and dwindling liquid assets, the pension board suspended redemptions. The funding ratio is now estimated to be around 36%, with assets forecast to be exhausted in a decade. Everyone is looking to blame someone else, but not everyone has accepted that drastic pension cuts are inevitable.

The factors that led to Dallas pension fiasco are all too common. Politicians and their administrations often make decisions that are politically beneficial without taking into account financial reality. As financial markets tend to go up the escalator and down the elevator, it is not until a market crash that the unrealistic return assumptions are exposed and the funding ratio collapses.

This is when a second political reality kicks in. In Dallas, there are just under 10,000 participants in the pension plan compared to 1.258 million residents — less than 1% of the population. If Dallas chose to fully fund the pension plan, it would require an enormous increase in taxes. For current politicians, it is far easier to see pensions for a select group cut by half or more than it is to sell a massive tax increase.

Growing debt and pension obligations are signs of what is to come for many local and state governments who have been living beyond their means for decades.

Pew Charitable Trusts research estimates a $1.5 trillion pension funding gap for the states alone, with Kentucky, New Jersey, Illinois, Pennsylvania and California going backwards at a rapid rate. Using a wider range of fiscal health measures, the Mercatus Center has the five worst states as Kentucky, Illinois, New Jersey, Massachusetts and Connecticut. The table below shows the five state pension plans in Illinois, which have an average funded ratio of just 37.6%.

The problem for Chicago and others trying to pay their debt and pension obligations by raising taxes is that this makes them unattractive destinations for businesses and workers. Growth covers many sins, as growth creates more jobs and drags more people into the area. This increases the tax base and lessens the burden from previous commitments on those already there. Well-managed, low-tax jurisdictions benefit from a positive feedback loop.

For states and municipalities in decline, their best taxpayers are the first to leave when the tax burden increases. Young college-educated workers with professional jobs generate substantial income and sales-tax revenue but require little in the way of education and health-care expenditure. They can easily relocate. Chicago and Illinois are bleeding people, with the flight of millionaires particularly detrimental on revenues.

Those who own property are caught in a catch 22; property taxes and a declining population have pushed property prices down, potentially creating negative equity. But staying means a bigger drain on the household budget as property taxes are the most efficient way to raise revenue and therefore become the tax increased the most. Bankruptcy becomes inevitable as a poorer and older population base that remains simply cannot support the debt and pension obligations.

The playbook from the Detroit bankruptcy is likely to be used repeatedly in the coming decade. Pensions will be reduced to match the available assets and the ability of the government’s budget to provide some contribution. If the government doesn’t have capacity or the legal obligation to contribute more, pensioners should expect their payments to be cut to something like the funding percentage. For Dallas and the pension plans in Illinois, this means payments cut by more than half.

Financial debtors will also suffer losses. Bondholders and lenders don’t vote and they are seen as a bunch of faceless wealthy individuals and institutions who mostly reside out of state. They effectively rank behind pensioners, who predominantly reside in the state and who vote, even though the two groups technically might rank equally. This makes state and local government debt a great candidate to short via buying CDS protection as the recovery rate for unsecured debt is usually awful in the event of default.

The next crisis will trigger an avalanche

At the risk of being labelled a Meredith Whitney-style boy who cried wolf, I expect the next financial crisis will trigger a wholesale revaluation of the creditworthiness of U.S. state and local government debt. I have no crystal ball for when this will happen, but it is almost certain that the next decade will contain another substantial decline in asset prices. This will impact state and local governments and their pension obligations in two major ways.

The continued use of such high return assumptions is unrealistic. The largest U.S. public pension fund, Calpers, has recognized this and is reducing its return expectations from 7.50% to 7.00% over three years. This still implies a 10% return on equities for a 60/40 portfolio.

Secondly, downturns cause a reassessment of all types of debt. State and local governments with a history of increasing indebtedness and no realistic plan for reducing their debts may become unable to borrow at any price. This will force them to seek bankruptcy or an equivalent restructuring process.

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